Small Caps, Tech Prop Up Market

Market Summary

Dow Industrials and S&P 500 broke their four-week win streak. The tech-heavy Nasdaq 100 had a record close as the sector has seen a robust earnings season. Volume was strong as investors wrapped up July. About 7.3 billion shares changed hands on U.S. exchanges, above the nearly 6.6 billion daily average over the past 20 sessions. For the week, the S&P 500 and small cap Russell 2000 basically finished even and the Blue Chip-heavy Dow Jones Industrial Average was down .7%. The Nasdaq Index was once again the big mover climbing 1.3%.

A tool to help confirm the overall market trend is the Bullish Percent Index (BPI). The Bullish Index is a popular market "breadth" indicator used to gauge the internal strength/weakness of the market. It is the number of stocks in an index (or sector) that have point & figure buy signals relative to the total number of stocks that comprise the index (or sector). So essentially it is the percentage of stocks that have buy signals. Like many of the market internal indicators, it is used both to confirm a move in the market and as a non-confirmation and therefore divergence indication. If the market is strong and moving up, the BPI should also be moving higher as more and more stocks are purchased. Nasdaq stocks are leading the market higher as quarterly earning numbers have enticed investors. Strength in technology and small cap stocks are primarily propping up the market. As long as the BPCOMPQ remains in an uptrend expect the overall stock market to remain near all-time highs.

Unlike technology and small capitalization stocks, large cap shares are a drag on the overall market. You can see in the chart below how the DJ Industrials and Transports confirm a downtrend while the Nasdaq Index reached all-time highs. If technology and small caps reverse course and fall along with the DOW you can expect the next significant market pullback.

In the chart below, the U.S. dollar slumped versus major rivals last week, slumping after weaker-than-expected second-quarter gross domestic product data, while the yen rallied after the Bank of Japan delivered a smaller-than-expected round of additional stimulus. The weak data "crushed" the dollar, said Christopher Vecchio, currency analyst at DailyFX, in a note. "The trend over the last few years has been a slow first quarter and a strong spike in the second, but this is clearly a miss," he said. Treasury prices jumped as buyers rushed in after a dovish Fed announcement. Treasury prices ended July with a second straight monthly advance, leading yields to tumble by the largest amount since February amid worries over the U.K.'s vote to exit the European Union and dovish stances by central banks across the world. Gold also reversed this week and rose 2.7% as investors have got nervous and started bidding on safe-haven assets following weak GDP numbers.

Market Outlook

Market pundits report howWall Street, seeking direction as the S&P 500 has been stuck in a narrow trading range for 12 days, will next week shift its attention from second-quarter corporate earnings reports to economic data. Investors will be looking for signs of economic strength to reinforce the positive direction hit Friday, when the S&P 500 hit an intraday record high. "I think the economy in the U.S. is getting better and still can improve. The overall tone will be of an economy that is getting better at a reasonable pace," said John Manley, chief equity strategist at Wells Fargo Funds Management in New York. The U.S. stock market has been trading flat as second-quarter earnings have come in better than initially expected, but the outlook for third-quarter earnings has worsened. In fact, the S&P 500 traded in a less-than-1 percent range throughout the 12 sessions to Friday, a lull not seen in data going back to 1970, according to Ryan Detrick, the senior market strategist at LPL Financial. At the start of the 3rd quarter US stocks remain near record highs, in part due to easy-money policies enacted by the US Federal Reserve and other central banks. "We're basically at all-time highs, but the market is evaluating whether there is reason to break out another leg higher," said David Levy, portfolio manager at Republic Wealth Advisors.

Put/Call Ratio is the ratio of trading volume of put options to call options. The Put/Call Ratio has long been viewed as an indicator of investor sentiment in the markets. Times where the number of traded call options outpaces the number of traded put options would signal a bullish sentiment, and vice versa. Technical traders have used the Put/Call Ratio for years as an indicator of the market. Most importantly, changes or swings in the ratio are seen as instances of great importance as this is commonly viewed as a change in the tide of overall market sentiment. The current ratio indicates traders have suddenly started buying put contracts, probably as insurance to protect unrealized gains from the current bullish move.

The CBOE Volatility Index (VIX) is known as the market's "fear gauge" because it tracks the expected volatility priced into short-term S&P 500 Index options. When stocks stumble, the uptick in volatility and the demand for index put options tends to drive up the price of options premiums and sends the VIX higher. In the chart below the Volatility Index is at the lowest level since this time last year. You can see the VIX is at its long-term support level where it usually doesn't sink any lower. The VIX is low enough for a stock market correction that will likely surprise investors.

The American Association of Individual Investors (AAII) Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The current survey result is for the week ending 07/27/2016. Pessimism among individual investors about the short-term direction of the stock market is at a four-week high, though continuing to remain below average, in the latest AAII Sentiment Survey. Neutral sentiment rose back above 40%, while optimism slipped. Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.2 percentage points to 31.3%. The drop keeps optimism below its historical average of 38.5% for a 38th consecutive week and for the 71st out of the past 73 weeks. Bullish sentiment remains within its typical historical range, however. Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.5 percentage points to 40.3%. The rise puts neutral sentiment back at an unusually high level. This is the 26th consecutive week that neutral sentiment is above its historical average of 31.0%. Bearish sentiment rose to a four-week high, though it still remains below its historical average. Bearish sentiment, expectations that stock prices will fall over the next six months, rose by 1.7 percentage points to 28.4%. Pessimism was last higher on June 29, 2016 (33.4%). The historical average is 30.5%. As noted last week, this is the just the second time this year that optimism has stayed above 30% on consecutive weeks. The comparatively higher level of bullish sentiment comes as the major large-cap indexes trade at or near their record highs, though some (but not all) individual investors have doubts about the ability of stocks to hold their current price levels.

The National Association of Active Investment Managers (NAAIM) Exposure Index represents the average exposure to US Equity markets reported by NAAIM members. The blue bars depict a two-week moving average of the NAAIM managers' responses. As the name indicates, the NAAIM Exposure Index provides insight into the actual adjustments active risk managers have made to client accounts over the past two weeks. The current survey result is for the week ending 07/27/2016. Second-quarter NAAIM exposure index averaged 60.52%. Last week the NAAIM exposure index was 92.64%, and the current week's exposure is 101.02%. As seen in the chart below money managers have highest level of equity exposure in several years. In fact, professional investors have gotten to the point where they are borrowing funds to invest in the stock market. It may not happen for a while, but as long as equity exposure remains elevated if stock prices do fall the market will drop hard as money manager unwind leveraged positions.

Trading Strategy

As reported by Jeff Hirsh in the Stock Trader's Almanac, large July gains have frequently been followed by a late-summer or autumn selloff and better buying opportunities than now. The table below of big July gains and subsequent declines since 1950 gives you a good look at the kind of buying opportunities that have occurred in the past following full-month July gains in excess of 3.5%.

The Fed continues its Dovish outlook despite better economic data and a solid economy. You can see in the graph below how small and midcap stocks are holding up better than the large caps of the Dow and S&P 500 as group rotation into technology and health care continues to absorb any selling. The S&P 500 remains extended, and that's one reason for the swap to the smaller cap and tech stocks.

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